Developed Countries

Most recent Standard and Poor’s data show that SPX buybacks collapsed to $88bn in Q2, from roughly $200bn in Q1, which is a whopping 67% quarter-over-quarter fall. Such a corporate buyer’s strike is negative for the near-term prospects of the S&P 500, but we expect buybacks to come back as the V-shaped economic recovery all but guarantees a rebound sometime in 2021 (top panel). Importantly, CEO confidence has also slingshot higher and coupled with the overall economic recovery, will pave the way for a resumption of shareholder friendly activities (middle panel). Bottom Line: Artificial EPS boosting via equity retirement will come back in 2021, especially in light of the ZIRP that is here to stay for the next five-seven years. For more details, please refer to this Monday’s Weekly Report.

Highlights Currency markets remain vulnerable to the upcoming US election, Brexit, and a resurgence of Covid-19 infections. Meanwhile, President’s Trump suggested “piecemeal” fiscal deal increases the odds of a correction in the near term. Stay short USD/JPY as a core holding. We eventually expect the passage of a fiscal deal, regardless of who is in the White House. This will favor pro-cyclical trades. CAD/USD is likely to continue strengthening versus the dollar, but underperforming at the crosses. The key reason is that, in the short term, even with an oil price recovery, Canadian crude will remain trapped in Alberta, keeping the WCS-to-WTI discount wide. Meanwhile, domestically, while the Canadian economy has bottomed, a resurgence in new Covid-19 cases puts this recovery at risk. We therefore expect the loonie to touch 80-82 cents but underperform the Australian dollar, Swedish krona, and Norwegian krone. Go short CAD/NOK for a trade. Feature Chart I-1The CAD Has Been A Laggard Since the DXY index peaked on March 19, the Canadian dollar has been an underperformer. Among its G10 peers, only the safe-haven currencies such as the Swiss franc and Japanese yen trail behind the loonie. This is remarkable since other commodity currencies such as the Norwegian krone and Australian dollar have posted very handsome returns since the March lows (Chart I-1). The natural question is whether the loonie’s underperformance is a sign of mispricing, or if other fundamental factors are at play? If the latter, then what are the key drivers of this underperformance and what sort of returns can we expect from the loonie over the next six to 12 months? Finally, are there any opportunities at the crosses that investors can capitalize on? The Loonie: Key Drivers The key drivers of the Canadian dollar are what happens to natural resource prices, specifically crude oil, and the Bank of Canada’s monetary policy stance relative to the Federal Reserve. As a major oil-producing nation, it is well known that an important driver of the loonie has been the price of crude oil. This is because rising domestic income from higher oil prices boosts aggregate demand. This comes both from the private sector through increased capital spending, more hiring and increased wages, and from government spending afforded by higher tax revenues and royalty income. As a result, the higher aggregate demand provides room for the BoC to hike interest rates. As a major oil-producing nation, it is well known that an important driver of the loonie has been the price of crude oil. Meanwhile, an increase in oil prices also implies rising terms of trade. This improves balance-of-payment dynamics, allowing the fair value of the exchange rate to rise in the process. As such, the rise in the currency does not necessarily tighten financial conditions. It is quite remarkable that for most of the last two decades, the difference between Canadian and US interest rates can be explained by swings in the oil price. This in turn has been a powerful driver of the Canadian dollar (Chart I-2). Chart I-2Policy Rates Follow The Oil price Chart I-3A Significant Resource Sector In Canada This should not come as a surprise. As a share of GDP, resources account for almost 20% of the Canadian economy (Chart I-3). The share of commodity exports is also a quite significant at 23%. While the share of services in the economy has risen, much of this is in the orbit of mining and oil and gas extraction support services. In a nutshell, the Canadian economy remains a resource-based one, making the outlook for resources, specifically crude oil, an important consideration. Where To Next For Canadian Crude? The oil industry has been hit by multiple tectonic shocks, including a sudden stop in economic activity, a fallout from the OPEC cartel, divestment from ESG funds, and falling oil intensity in many economies. Just over a decade ago, the price of crude oil was firmly above $100 per barrel. Fast forward to today and many blends are trading south of $45 per barrel (Chart I-4). Chart I-4Many Blends Are Trading Below Going forward, the path for oil prices will be highly dependent on the interplay between demand and supply. Oil demand tends to follow the ebbs and flows of the business cycle, with over 60% of global petroleum consumed by the transportation sector. As a result, crude oil prices have largely tracked Apple mobility data (Chart I-5). Many countries are now entering renewed restrictions due to the second wave of the pandemic, which is showing up in a slowdown in traffic. However, as we discussed last week, the economic effects should be far less lethal that what we experienced in the first half of this year. The reasons include the potential for a vaccine soon and a substantial drop in mortality rates. Our commodity strategists expect oil prices to average $65 per barrel next year, much more than is currently priced in the futures curve. Crude oil prices have largely tracked Apple mobility trends data.  From a bird’s-eye view, oil prices are more likely to enter a broad trading range, as they did in the ‘80s and ‘90s, than a structural bull market. On the positive side, we have probably seen a bottom in oil prices, in that it is unlikely we will revisit negative price territory. However, history suggests that it takes quite a long time for excesses to clear in the oil market. The bull market of the 1970s was followed by a 20-year bear market, as OPEC production surged (Chart I-6). This time around, US shale production has gained significant market share, and with the electrification of the modern economy, a lot of barrels may need to be taken off the market to induce a genuine bull market. Chart I-5Oil Prices Have Tracked The Recovery In Traffic Chart I-6A Secular View On ##br##Oil Prices Canadian players suffer from two additional hiccups: First, the International Maritime Organization has introduced new standards for bunker fuel since January 2020 (IMO 2020). According to the new standards, sulphur content must be cut from 3.5% to 0.5%. Canada’s Western Canadian Select (WCS) blend is one of the world’s heavier crudes with a sulphur content north of 3.5%. This is expected to significantly widen the discount between WCS and light sweet crude. This is bad news for Canadian oil producers. Second, pipeline capacity remains a major hurdle to getting Canadian crude to US refineries. This leads to a transportation discount for Canadian crude oil. The Enbridge Line 3 replacement is facing delays from the state of Minnesota (390K additional barrels). The future of the Keystone XL pipeline, a major release valve for Canadian oil (830K barrels a day in capacity), rests on the US election. Former Vice President Joe Biden has opposed the project, calling Alberta’s oil “tar sands that we don’t need.” The Trans Mountain Expansion project (690K additional barrels), connecting Alberta to the Westridge Marine Terminal and Chevron refinery in Burnaby, is slated to be competed only by the end of 2022. All this could widen the discount between WCS and WTI crude oil, hurting the Canadian dollar in the process (Chart I-7). There are offsetting factors. The drop in Venezuelan oil production has allowed Canadian producers to gain market share in the heavy crude oil market. Production cuts in Alberta have also helped mitigate the oversupply of heavy crude. Canadian oil exports are near record highs, despite the fact that the US is rapidly becoming energy independent (Chart I-8). As a share of imports, Canadian crude represents about half of the US’s intake (Chart I-9). This highlights the importance of heavy crude in oil market dynamics. Specifically, a lot of refining capacity in the US has been fine-tuned to handle the cheaper but heavier blend from Canada. Chart I-7Canadian Oil Discount Could Widen Chart I-8Big US Demand For Canadian Oil Chart I-9Big US Demand For Canadian Oil Netting it all out, we will expect crude oil prices to head to $65 per barrel, while the Canadian discount to widens to $20 per barrel before slowly recovering. This should provide modest upside for the Canadian dollar as terms of trade continue to improve. A Regime Shift Chart I-10Oil Production: US Versus Canada There has been a paradigm shift in oil production, with US shale producers aggressively grabbing market share from both OPEC and non-OPEC producers. Currently, Canada produces only 5.5% of global crude versus 15% for US production. Admittedly, the Canadian market share has also been rising, but the tectonic shift in US production has severely dampened the positive correlation between crude prices and the loonie (Chart I-10). In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around 2010 when US production was about to take off. Since then, that correlation fell from around 0.9 to about 0.2 (Chart I-11). The loss of shale output during the recent downturn has somewhat re-established a strong correlation between petrocurrencies and the crude oil price (bottom panel). But more importantly, should global demand pick up, US shale output will rise again and redistribute market share away from both OPEC and other non-OPEC members and towards the US. Chart I-11Negative Correlation Between Petrocurrencies And Crude Oil Restored Take the Mexican peso as an example. Since 2013, Mexico has become a net importer of oil, as the US moves towards becoming a net exporter. This explains why the positive correlation between the peso and oil prices has weakened significantly in recent years. Put another way, rising oil prices benefit US domestic income much more than they did in the past, while the benefits for countries like Canada and Mexico are slowly fading. The Canadian crude market share has been rising, but the tectonic shift in US production has severely dampened the positive correlation between crude prices and the loonie.  The second seismic shift in oil markets has been the ESG wave. With awareness towards global warming and climate change gaining mainstream support, divestments from energy assets has picked up steam. Currency markets react to net portfolio flows, and divestments from the energy sector in particular and the commodity sector in general have been behind the huge underperformance of the Canadian dollar since 2011 (Chart I-12). Chart I-12Huge Underperformance Of Canadian Equities The good news is that a lot has already been priced in. First, global energy stocks have been in a 12-year bear market in relative performance terms. This represents a 70% peak-to-trough decline, with the latest selloff being symptomatic of a capitulation phase. Second, at a price-to-book discount of 64% and a dividend yield of 7%, energy stocks are very cheap (Chart I-13). Chart I-13A Capitulation In Energy Stocks? It is remarkable that long-term portfolio flows into Canadian assets have started picking up, a sign of bargain hunting by international investors (Chart I-14). This should provide a modest tailwind to the Canadian dollar over the next six to 12 months. Chart I-14A Recovery In Canadian Portfolio Inflows Improving Domestic Conditions The Canadian domestic economy has been holding up well, despite lower oil prices. This has occurred on the back of massive fiscal stimulus, in addition to the BoC dropping rates to 0.25% and engaging in quantitative easing. During his Throne Speech a fortnight ago, Canadian Prime Minister Justin Trudeau vowed to do “whatever it takes” to support people and businesses throughout the crisis. Fitch Ratings estimates that the budget deficit in Canada will remain wide going into 2022 (Chart I-15). Meanwhile, as lockdown measures have eased since April, incoming data has been robust. Chart I-15Lots Of Fiscal Stimulus In Canada Canada continues to create record employment, with 246,000 new jobs added in August. This is leading to the fastest recovery in the unemployment rate on record (Chart I-16). The manufacturing and resources sectors in Quebec, Alberta, and British Columbia, which bore the brunt of the employment declines, are rebounding. Chart I-16Best Job Recovery In Decades Most measures of household confidence are in a V-shaped recovery. Retail sales in Canada have rebounded, reaching above pre-pandemic levels. Mortgage credit has also picked up strongly. Correspondingly, housing starts have overtaken their pre-pandemic peak as well, with new home construction at its highest level since 2007. Working from home has led to a surge in renovation projects. Meanwhile, low rates and rising home prices have encouraged new construction. Residential investment is almost 7% of Canadian GDP, a significant chunk of aggregate demand (Chart I-17). Despite the improvement in domestic conditions, inflationary pressures remain moribund. The output gap measure according to the BoC remains wide at -3.2% of GDP. The latest inflation print shows that domestic prices in Canada still remain anchored below the midpoint of the BoC’s target band. This means that the BoC will be in no rush to normalize policy anytime soon (Chart I-18). Chart I-17Residential Construction Is Important Chart I-18Canadian Inflation Is Below Target Given the government’s commitment to step in as a spender of last resort, real rates in Canada will remain depressed as inflation starts to recover. This will not be as pronounced versus the US, where the Fed is trying to asymmetrically generate inflation, but more so against its commodity peers such as Australia and Norway, where the number of new Covid-19 cases remains under control, giving the governments there less incentive to significantly increase spending. This suggests that while the loonie may have upside against the dollar, it could underperform at the crosses. Investment Implications We expect the CAD/USD to gravitate higher in the next few months. The key catalysts are favorable interest rates versus the US and a gradual recovery in WCS oil prices as global economic activity picks up. From a fundamental perspective, the CAD is still undervalued by 7.3% on a trade-weighted basis (Chart I-19). This puts 80-82 cents within striking distance. Chart I-19The CAD Is Still Cheap Chart I-20Sell CAD/NOK Relative to other commodity currencies, transportation bottlenecks in Canada will prove to be a formidable hurdle in closing the current discount between WCS and WTI and/or Brent. While Canadian crude is likely to remain trapped in the oil sands for now, North Sea crude will face fewer transportation bottlenecks in the near term. This suggests that the path of least resistance for the CAD/NOK is down (Chart I-20). Sell CAD/NOK for a trade. An improvement in economic activity in Asia relative to the West will also favor AUD/CAD. Rising oil prices are a terms-of-trade boost for oil exporters but lead to demand destruction for oil importers. In general, a strategy for playing oil upside is to be long a basket of energy producers versus energy consumers. This suggests that the CAD has upside against the euro, the Indian rupee, and the Turkish lira. We are already long a basket of petrocurrencies versus the euro. Finally, we are long CAD/NZD as a play on policy divergences between the Reserve Bank Of New Zealand and the BoC. However, our conviction on this trade is low due to the resurgence of new cases in Canada. We recommend maintaining tight stops on this position.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data from the US have been positive: The unemployment rate fell from 8.4% to 7.9% in September. Nonfarm payrolls increased by 661K. The ISM Non-manufacturing Index increased from 56.9 to 57.8 in September. The Michigan Consumer Sentiment Index jumped from 74.1 to 80.4 in September. The trade deficit widened from $63.4 billion to $67.1 billion in August. Initial jobless claims increased by 840K for the week ending on October 3. The DXY index fell initially but then recouped the loss, ending flat this week. Trump’s tweet on Tuesday about “halting COVID-19 relief talks until after election” largely reduced the likelihood of any imminent fiscal stimulus. While pre-election uncertainties have been dominant recently, we remain dollar bears in the cycle, especially in a post-election and post-vaccine world. Report Links: Tail Risks In FX Markets - October 2, 2020 The Message From Dollar Sentiment And Technical Indicators - Sept. 25, 2020 Addressing Client Questions - September 4, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: Headline inflation declined from -0.2% to -0.3% year-on-year in September. Core inflation also decreased from 0.5% to 0.2%. The Markit Services PMI edged up from 47.6 to 48 in September. The Sentix Investor Confidence Index increased from -9.5 to -8.3 in October. Retail sales grew by 3.7% year-on-year in August. The euro rose by 0.2% against the US dollar this week. The slip in core inflation this week reinforced the concern about deflation. In the recent strategic review, Christine Lagarde kept a dovish tone and reiterated a desire to keep policy accommodative. We believe that the PEPP with a total envelope of €1,350 billion through the end of June 2021 will continue to support euro area economic recovery. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been positive: The Jibun Bank Services PMI increased from 45 to 46.9 in September. The current account surplus surged from ¥1.5 trillion to ¥2.1 trillion in August. The Eco Watchers Survey Outlook Index increased from 42.4 to 48.3 in September. The Current Conditions Index also grew from 43.9 to 49.3. The Japanese yen declined by 0.3% against the US dollar this week. Incoming data confirms that the Japanese economy is recovering from pre-pandemic lows. Apart from being a cheap safe-haven hedge, the Japanese yen is also supported by lower COVID infection rates and fewer political uncertainties. Stay short on USD/JPY. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data from the UK have been positive: The Markit Services PMI increased from 55.1 to 56.1 in September. House prices grew by 2.3% year-on-year in July. Unit labor costs surged by 27.4% year-on-year in Q2. The British pound has been flat against the US dollar this week. Despite ongoing Brexit chaos, the pound managed to remain well above 1.27 in recent months. Our bias is that a Brexit deal will eventually be reached. We favor the British pound relative to the euro since the pound is tremendously undervalued against the euro. Besides, risk reversals also suggest that the pound is deeply oversold. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data from Australia have been mixed: The Commonwealth Bank Services PMI increased from 50 to 50.8 in September. Exports declined by 4% month-on-month in August while imports expanded by 2%. The trade surplus narrowed from A$4.65 billion to A$2.6 billion.   The NAB Business Confidence Index increased from -8 to -4 in September. The Australian dollar fell by 0.3% against the US dollar this week. On Tuesday, the RBA kept its interest rate steady at 0.25%. Governor Philip Lowe acknowledged the weakness in Australia’s labor market and highlighted that the RBA continues to consider various measures designed to support job growth as the economy opens further. We remain positive on the Australian dollar. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: The ANZ Business Confidence Index improved from -28.5 to -14.5 in October. The Activity Outlook index also shifted from -5.4 to 3.6 in October. The New Zealand dollar fell by 1.1% against the US dollar this week. While still well below pre-pandemic levels, the ANZ Business Confidence Index has undoubtedly improved in October. Investment and employment intensions both moved higher, lifting profit expectations. That said, the services sector is still under severe pressure resulting from strict lockdown measures. Markets are now pricing in a higher than 50% probability of a further rate cut by early next year, which contributes to the relative weakness in the New Zealand dollar. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: The trade deficit marginally narrowed from C$2.53 billion to C$2.45 billion in August. The Ivey PMI declined from 67.8 to 54.3 in September. Housing starts increased by 209K in September, down from 261.5K in the previous month. The Canadian dollar appreciated by 0.3% against the US dollar this week. As an important oil producer and exporter, the Canadian dollar shifts along with the price of oil. In this week’s report, we discuss the key drivers behind the Canadian dollar and discover why it has underperformed other G10 pro-cyclical currencies. Please refer to our front section for more detailed research. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data from Switzerland have been positive: Total sight deposits continue to increase from CHF 704.5 billion to CHF 705.1 billion for the week ending on October 2. The unemployment rate declined from 3.4% to 3.3% in September. The Swiss franc appreciated by 0.2% against the US dollar this week and nearly 6% since January. The unwanted appreciation has been a headache for the SNB, which warrants more intervention against a pricey franc. Interestingly, the franc has been flat against the euro year-to-date. We are looking to buy EUR/CHF on weakness due to the SNB’s intervention and the CHF’s lower beta to growth. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data from Norway have been positive: The industrial production index increased by 1.1% month-on-month in August.  Manufacturing output increased by 3% month-on-month in August. The Norwegian krone rose by 0.7% against the US dollar this week. Incoming data from Norway is consistent with the recent economic recovery there, especially in the resources sector. Industrial production of mining and quarrying, basic metals, and machinery equipment jumped, respectively, by 10.1%, 8.8% and 15.7% month-on-month in August. We continue to favor the Norwegian krone and are looking to purchase the Nordic basket again at a more favorable price. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been positive: Industrial production increased by 0.2% year-on-year in August, or 7% month-on-month. Manufacturing new orders was unchanged year-on-year in August, but that’s up from a 6.9% contraction in the previous month. The budget balance shifted from a surplus of SEK 19.8 billion to a deficit of SEK 13.1 billion in September. The Swedish krona increased by 0.6% against the US dollar this week. As a bellwether of global growth, Swedish manufacturing activity is one of the indicators we monitor closely in order to gauge where we are in a cycle. Despite recent uncertainties, the Swedish manufacturing sector is showing budding signs of recovery, which is bullish for the Swedish krona. Kelly Zhong Research Analyst Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Both public opinion polls and betting markets suggest that Joe Biden will become President, with the Democrats gaining control of the Senate and retaining the House of Representatives. Such a “blue wave” would have mixed effects on the value of the S&P 500. On the one hand, corporate taxes would rise under a Biden administration. On the other hand, trade relations with China would improve. The Democrats would also push for more fiscal stimulus, which the stock market would welcome. The odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. In a blue wave scenario, the Democrats will enact $2.5-to-$3.5 trillion in pandemic relief shortly after Inauguration Day. Joe Biden‘s platform also calls for around 3% of GDP in additional spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Unlike in late 2016, the Fed is in no mood to raise interest rates. Large-scale fiscal easing will push down the value of the US dollar, while giving bond yields a modest boost. Non-US stocks will outperform their US peers. Value stocks will outperform growth stocks. Looking further out, Republicans will move to the left on economic issues, leaving corporate America with no clear backer among the two major parties. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade. Look, Here's The Deal: Joe Biden Is In The Lead With four weeks remaining until the US presidential election, Joe Biden remains on course to become the 46th president of the United States. According to recent public opinion polls, the former vice president leads Donald Trump by 10 percentage points nationwide, and by 4 points in battleground states (Chart 1). Far fewer voters are undecided today compared to 2016. This suggests that there is less scope for President Trump to narrow his deficit in the polls. Betting markets give Biden a 68% chance of prevailing in the race for the White House (Chart 2). They also assign a 67% probability that the Democrats will take control of the Senate and 89% odds that they will retain their majority in the House of Representatives. Chart 1Opinion Polls Favor Biden ... Chart 2.... As Do Betting Markets   Mixed Impact On The S&P 500 What would the market implications of a “blue wave” be? Our sense is that the overall impact on the value of the S&P 500 would be small, largely because some negative repercussions from a Democratic sweep would be offset by positive repercussions. On the negative side, Biden has pledged to raise the corporate income tax rate from 21% to 28%, bringing it halfway back to the 35% rate that prevailed in 2017. He has also promised to introduce a minimum of 15% tax on the income that companies report in their financial statements to shareholders, raise taxes on overseas profits, and lift payroll taxes on households with annual earnings in excess of $400,000. Together, these measures would reduce S&P 500 earnings-per-share by 9%-to-10%. On the positive side, while geopolitical tensions will persist, US trade relations with China would likely improve if Joe Biden were to become the president. Biden has roundly criticized Trump’s tariffs, saying that they are “crushing farmers” and “hitting a lot of American manufacturing… choking it to within an inch of its life.”1 He has pledged to honor multilateral agreements. The World Trade Organization concluded on September 15 that Trump’s tariffs violated international trade rules. This judgement and the desire to turn the page on the Trump era could give Biden the impetus to eventually roll back some of the tariffs. In contrast, having been stricken by what he has called the “China virus,” Trump could take things personally and retaliate with a flurry of new punitive measures.  Fiscal policy would be further loosened in a blue wave scenario, an outcome that the stock market would welcome. Voters would also applaud more pandemic relief. Table 1 shows that 72% of Americans, including the majority of Republicans, support the broader contours of the $2 trillion stimulus package that President Trump has rejected. Table 1Voters Support A New $2 Trillion Coronavirus Stimulus Package By A Fairly Wide Margin At this point, the odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. If Biden wins and the Republicans lose control of the senate, the Democrats would likely enact a stimulus package worth $2.5-to-$3.5 trillion shortly after Inauguration Day on January 20. In addition to pandemic-related stimulus, Joe Biden has called for around 3% of GDP in spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Only about half of those expenditures would be matched by higher taxes, implying substantial net stimulus for the economy. A Weaker Dollar And Modestly Higher Bond Yields The greenback jumped on Tuesday after President Trump said he is breaking off negotiations with the Democrats over a new stimulus bill. This suggests that the dollar will weaken if fiscal policy is loosened. If that were to happen, it would be different from what transpired following Trump’s victory in 2016 when the dollar strengthened. Why the disconnect between now and then? The answer has to do with the outlook for monetary policy. Back then, the Fed was primed to start raising rates again – it hiked rates eight times beginning in December 2016, ultimately bringing the fed funds rate to 2.5% by end-2018 (Chart 3). This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023. This suggests that nominal bond yields will rise less than they did in late 2016. Since inflation expectations will likely move up in response to more stimulative fiscal policy, real yields will rise even less than nominal yields. Over the past 18 months, US real rates have fallen a lot more in relation to rates abroad than what one would have expected based on the fairly modest depreciation in the US dollar (Chart 4). If US real rates remain entrenched deep in negative territory, while the US current account deficit widens further on the back of strong domestic demand, the dollar will continue to weaken. Chart 3Trump Victory Was Followed By Rising Interest Rates Chart 4A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials   Favor Non-US And Value Stocks Non-US stocks typically outperform their US peers when the dollar is weakening (Chart 5). This partly stems from the fact that cyclical stocks are overrepresented in stock markets outside of the United States. It also reflects the fact that cash flows denominated in say, euros or yen, are worth more in dollars if the value of the dollar declines. Chart 5A Weaker Dollar Tends To Benefit Cyclical And Non-US Stocks Financial stocks are overrepresented outside the US (Table 2). They are also overrepresented in value indices (Table 3). While a Biden administration would subject the largest US banks to additional regulatory scrutiny, the impact on their bottom lines would likely be small. US banks have been living under the shadows of the Dodd-Frank Act for over a decade. Today, banks operate more as stable utilities than as cavalier casinos. Table 2Financials Are Overrepresented In Ex-US Indexes, While Tech Dominates The US Market Table 3Financials Are Overrepresented In Value, While Tech Dominates Growth Indexes Stronger stimulus-induced growth next year will allow many banks to release some of the hefty provisions against bad loans that they built up this year, while modestly steeper yields curves will boost net interest margins. Tech stocks are overrepresented in growth indices. Better trade relations would help US tech companies, as would a weaker dollar. That said, Joe Biden’s plan to increase taxes on overseas profits would hit tech companies disproportionately hard since the tech sector derives over half its revenue from outside the United States. Stepped up antitrust enforcement and more stringent privacy rules could also weigh on tech profits. On balance, while there are many moving parts, a Democratic sweep would favor non-US equities over US equities, and value stocks over growth stocks. Trumpism Transcends Trump Chart 6Trump Targeted Socially Conservative Voters In 2016, we bucked the consensus view that Hillary Clinton would win the election. On September 30, 2016, we predicted that “Trump will win and the dollar will rally,” noting that “Trump has seen a huge (yuge?) increase in support among working-class whites. If the so-called “likely voters” backing Clinton are, in fact, less likely to turn out at the polls than those backing Trump, this could skew the final outcome in Trump's favor.”2 Right-wing populism was the $1 trillion bill lying on the sidewalk that no mainstream Republican politician seemed eager to pick up. According to the Voter Study Group, only 4% of the US electorate identified as socially liberal and fiscally conservative in 2016, compared to 29% who saw themselves as fiscally liberal and socially conservative (Chart 6). The latter group had no political home, at least until Donald Trump came along. Rather than waxing poetically about small government conservatism – as most establishment Republicans were wont to do – Trump railed against mass immigration, unfair trade deals, rising crime, never-ending wars, and what he described as out-of-control political correctness. While Trump was able to carry out parts of his protectionist agenda, most of his other actions fell well short of what he had promised. His only major legislative achievement was a massive tax cut for corporations and wealthy individuals – something that the vast majority of his base never asked for. The Rich Are Flocking To The Democratic Party How did corporations and wealthy Americans reward Trump for lowering their taxes? By shifting their allegiances towards the Democrats, that’s how. According to the Pew Research Center, households earning more than $150,000 favored Democrats by 20 percentage points during the 2018 Congressional elections, a 13-point jump from 2016. Households earning between $30,000 and $149,999 favored Democrats by only 6 points in 2018. The only other income group that strongly favored Democrats were those earning less than $30,000 per year (Table 4). Table 4Democratic Candidates Had Wide Advantages Among The Highest-And-Lowest Income Voters Chart 7Democratic Districts Have Fared Better Over The Past Decade Other data tell a similar story. Median household income in Democratic congressional districts rose by 13% between 2008 and 2017. It fell by 4% in Republican districts. Today, on average, Republican districts have a median income that is 13% below Democratic districts (Chart 7). Campaign donations have shifted towards the Democrats. The latest monthly fundraising data shows that the Biden campaign received three times more large-dollar contributions in total than the Trump campaign. The nation’s CEOs have not been immune from this transformation. Seventy-seven percent of the business leaders surveyed by the Yale School of Management on September 23 said they would be voting for Joe Biden.3   As elites desert the Republican Party, will the Democratic Party start championing lower taxes and less regulation? That seems unlikely. According to the Voter Study Group, higher-income Democrats are actually more likely to support raising taxes on families earning more than $200,000 per year than lower-income Democrats (83% versus 79%). Among Republicans, the opposite is true: 45% of lower-income Republicans are in favor of raising taxes, compared to only 23% of higher-income Republicans.4  There used to be a time when companies tried to steer clear of the political limelight. This is starting to change. As the relative purchasing power of Democratic voters has risen, many companies have become emboldened to adopt overtly political stances on a variety of hot-button social and cultural issues, even if those stances alienate many conservative customers.  What does this imply for investors? If big business abandons conservative voters, conservative voters will abandon big business. Corporate America will be left with no clear backer among the two major parties. Over the long haul, this is likely to be bad news for equity investors. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  “Biden Takes On ‘Trump’s Tariffs’,” The Wall Street Journal, June 12, 2019. 2 Please see Global Investment Strategy Special Report, “Three (New) Controversial Calls,” dated September 30, 2016. 3 “CEO Caucus Survey: Business Leaders Fault Trump Administration on COVID and China,” Yale School of Management, September 24, 2020. 4 Lee Drutman, Vanessa Williamson, Felicia Wong, “On the Money: How Americans’ Economic Views Define — and Defy — Party Lines,” votersstudygroup.org, June 2019. Global Investment Strategy View Matrix Current MacroQuant Model Scores

Highlights President Trump is waffling on fiscal relief. Our constraints-based framework still points to a deal, but the odds have clearly fallen. US and global stocks have rallied despite the fiscal failure. Markets evidently believe stimulus is coming regardless, particularly if Democrats win a blue sweep – our base case election scenario. However, our quantitative election model has boosted Republican odds, flagging a major risk to the blue sweep scenario. Moreover a blue sweep will remove checks and balances on the new administration and thus bring negative surprises that the market is underrating. We maintain our tactical risk-off positioning on the expectation of another leg of election-related volatility. Over a 12-month time horizon we remain invested in reflation plays. Feature Financial markets came around to our “blue sweep” base case for the US election this week. Betting markets shifted sharply after the first presidential debate (Chart 1). Support for Biden surged in national opinion polls while Trump dropped off, albeit to a lesser extent in swing states. Worryingly for the White House, the few polls taken since Trump took ill with COVID-19 on October 2 do not show a sympathy bounce for the president (Chart 2). Chart 1Consensus Forms Around ‘Blue Sweep’ Base Case Chart 2Trump Takes A Dive With Little Time On Clock In a very dangerous turn for the president’s re-election chances, Trump discontinued negotiations with House Democrats over a fiscal relief bill, promising to pass a large new stimulus after the election. Partially walking back those comments, he said he would sign any targeted stimulus bills that Congress sends him in the meantime (such as a new round of $1,200 rebates for households). House Speaker Nancy Pelosi shot down the option of a skinny bill, as we have argued she would. Now they are going back and forth. While the S&P 500 rallied on the news, other reflation trades like US cyclicals, oil, and silver show the risk of premature fiscal tightening (Chart 3). Investors may have to wait until late January until getting a new infusion of government support. Chart 3Lack Of Stimulus Still A Risk To Reflation Trades Chart 4Market Rally Not Based On Blue Sweep Odds True, a fiscal deal could be passed in the lame duck session in November or December, but Republican Senators unwilling to pony up around $500 billion to bail out blue states – when they face a possible wipeout in a historic election – will be even less willing if they lose the election. They will be more hawkish since they will want to pin deficits on the Democrats in future. If Republicans retain control of the Senate despite the latest news – which is possible, especially given the Democratic candidate’s new vulnerability in the North Carolina race due to a sex scandal – then investors have two years of fiscal hawkishness to contend with. Diagram 1 highlights the market implications of this Senate risk. Diagram 1Scenarios For US Election Outcomes And Market Impacts So we need to look elsewhere to explain why the market rallied when odds of a fiscal deal fell. The above reasoning leaves us with the following options: The economy is recovering so robustly that new fiscal stimulus is unnecessary. This is not the view of Federal Reserve Chairman Jay Powell, who all but pleaded for Congress to conclude a deal to secure the recovery, or of other mainstream economists. Stimulus is coming regardless of election outcome. Congress will be forced to support the country during a slump. Debt monetization is the relevant point, even if there is a month-or-two delay in stimulus. Financial markets are cheering the higher odds of a Democratic clean sweep of Congress and the White House since it implies fiscal largesse. The market may already have discounted some of the impending tax hikes over the past month. The second explanation is the best but the third is rapidly becoming the new consensus on Wall Street. Chart 4 suggests there is no connection between the S&P rally and the odds of a blue sweep. With the Fed pursuing “maximum employment” and average inflation targeting, it makes sense that the real mover in the macro landscape has become fiscal policy. Hence the outcome that produces the most proactive fiscal policy is positive for financial markets. A blue sweep is verification of the shift toward debt monetization, which is missing from option two above. The problem is that a blue sweep also brings downside risks. Domestic policy uncertainty will only fall temporarily after the election if there is a blue sweep. Checks and balances will vanish. Eventually Democrats will become overweening in their policy agenda, delivering negative surprises to financial markets. A “New Deal”-style policy agenda would weigh on the corporate earnings outlook. For example, Democrats have refused to forswear removing the filibuster or stacking the Supreme Court, both of which would lie in their power and either of which would enable them to pass an ambitious “New Deal”-style policy agenda that would bring unforeseen consequences – largely in the direction of wealth redistribution away from corporations. Table 1What EPS Hit To Expect? Redistribution would start to correct US social and economic imbalances, improve middle class spending power, and boost consumption – but it would first weigh on the corporate earnings outlook. Net profit growth, which grew by 16% above what was otherwise expected due to the Trump tax cuts (Chart 5), could suffer more than the expected 11% one-off contraction (Table 1), as our US equity strategist Anastasios Avgeriou has shown. Chart 5Partial Repeal Of Trump Tax Cut Bad For Earnings New proposals will also emerge that the market is not taking account of. To take just the latest example, former Fed Chair Janet Yellen recently stated that the US could adopt a $40 per ton tax on carbon emissions under a Biden administration.1This proposal is not part of Biden’s official plan, hence not priced by markets along with Biden’s expected tax hikes (Table 2). But control of the Senate would make it a real option given Biden’s ambitious climate goals. Table 2Biden Needs Senate To Raise Taxes Consumer confidence in the US will suffer from political polarization. Recall that in 2016, the economy was in fine shape but Republicans did not believe it, weighing down the average until President Trump won the election. Today the economy is in a slump but Republicans may not recognize the bad news until President Trump loses. Democrats, for their part, will suddenly abandon their doom and gloom if Biden wins the election. Applying a comparable partisan shock to consumer confidence for 2021 would suggest that overall confidence will be lackluster (Chart 6). At least this is true until the passage of new stimulus and an advancing recovery outweigh the partisan effect. Chart 6Biden Will Not Recreate Trump Confidence Boost A similar case can be made that small business sentiment will worsen in a blue sweep scenario. Fear of higher regulation and taxes will spike and weigh on animal spirits (Chart 7). Historically the first year after an election sees smaller equity upside and larger downside with unified government as opposed to divided government (Chart 8). If this time is different it is because of the sea change in the US to embrace debt monetization. But that sea change occurred under a Republican administration and is likely to persist due to the output gap. Chart 7SMEs Will Fear Blue Wave Chart 8Stock Market Profile Fits Divided Government, Which Has More Upside A Republican Senate under a Biden presidency would bring higher fiscal risk, but the truth is that neither trade war risks nor corporate taxes would go up, yet Republicans would eventually have to concede to spending bills (just as Democrats did under Trump). Hence divided government is not as negative as it is made out to be as it contains mostly known quantities, whereas a blue sweep would lead the US in a redistributionist direction that is initially disruptive. Relative to divided government, it would be positive for aggregate demand but negative for corporate earnings. Bottom Line: US and global equities will rise over the coming 12 months on the back of eventual US stimulus and ongoing global stimulus. A blue sweep is our base case election outcome but it brings mixed results. Global equities would benefit more than US equities which will face a spike in taxes and regulation. US equities will still rise but they face more upside under a divided government in which Republicans halt tax hikes. Supreme Court Confirmation Looms Of course, a blue sweep outcome is not guaranteed. Indeed the fact that it is now consensus makes us nervous, as there are still 26 days until the election. Our quantitative election model gives the Republicans a 49% chance of winning the White House on the back of the V-shaped recovery in the states, which delivers Florida to the Republican camp, leaving Trump with 259 Electoral College votes (Chart 9). This probability is well above our subjective 35% judgment and the new market consensus on Trump’s odds. Chart 9Quant Election Model Gives Trump 259 Electoral College Votes And 49% Odds Of Victory Trump’s decision to break off the fiscal talks probably sealed his doom, but we would still maintain that a correct reading of the various political and economic constraints point toward a fiscal deal. Hence there is still some chance that a deal will be snatched from the jaws of defeat. At that point we would upgrade Trump’s chances to something closer to our election model. But it would not be bullish, as the market would need to price a higher risk of trade war. Subjectively Trump has a 35% chance of re-election, but our quant model flags a risk to this view. The market also must contend with COVID-19 risks (Charts 10A and 10B). Stimulus is necessary to prevent COVID-19 risks from hitting the market, as more distancing will be necessary in states where cases are rising. Chart 10ACOVID-19 Cases Rising Chart 10BCOVID-19 Hits Swing States The reason President Trump cut short the fiscal talks was to ensure that they would not interfere with the Senate’s ability to confirm his Supreme Court nominee Amy Coney Barrett. The confirmation hearings will go up for a floor vote in the Senate sometime around October 23, ensuring a massive constitutional brawl just ahead of the election. The dollar has more upside if Trump wins. Chart 11Risk: Trump Comeback Boosts The Greenback We do not expect this showdown to change the game, since boosting turnout among Trump’s conservative base will be insufficient in an election fought in the face of major national shocks that affect the median voter (pandemic, recession, social unrest). This election is already going to be a high turnout election – preliminary information suggests it could be the highest since 1908 at 65% of eligible voters2 — which means that Republicans will suffer from the leftward tilt of the median voter. However, if Trump’s polling improves between now and then – and if mFarkets inexplicably rally all month despite the withdrawal of fiscal support – then we could be surprised. Our quantitative model provides a basis for believing that Republicans are now underrated. This implies that the dollar has more upside in the near term as the risk of a contested election and/or a Trump second term, and hence another shock to the US political system and global trading system, must still be guarded against (Chart 11). Investment Takeaways The market faces near-term downside risk and volatility until the US fiscal support is restored. This is particularly the case as long as COVID-19 cases are not subdued. The rising odds of a blue sweep, our base case, is not sufficient to dampen volatility over the coming month. Depending on the election results, volatility will subside in November or January at the latest. Not only is a contested election a non-negligible risk – based on our quant model’s reading – but also President Trump will remain in office till January 20 and could easily dish out some negative surprises, particularly on China relations. Hence we are maintaining our tactical risk-off and safe-haven trades: long US treasuries, Japanese yen, US health care equipment stocks (which will outperform the overall sector amid the Democratic regulatory threat), and EUR-GBP volatility. Over the 12-month time frame, we have little doubt that the US adoption of debt monetization, in keeping with Chinese and global stimulus, will push equities and risky assets higher. The reflation trade remains the core of our strategic portfolio. Global stocks should outperform under a Biden presidency. Biden will be positive for global trade ex-China, as both US electoral politics and grand strategy will drive any administration to take a hard line on China, though Biden will not wield tariffs like Trump.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Matthew Green, "U.S. could adopt carbon tax under a Biden presidency, ex-Fed Chair Yellen says," Reuters, October 8, 2020, reuters.com; see also Group of Thirty, "Mainstreaming The Transition To A Net-Zero Economy," October 2020, group30.org. 2 See John Whitesides, "More than 4 million Americans have already voted, suggesting record turnout," Reuters, October 6, 2020, reuters.com.